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Factors that influence how reference price is formed
purchase context cost current prices past prices
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Lecture 3
Prospect theory Value creation
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Prospect Theory
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Option A Option B
Prospect Theory
Theory Consumers evaluate purchases as ______ and ______
relative to reference price
______ and _____ have a diminishing effect as they grow larger
Consumers are more sensitive to _____ than to _____
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Shape of the Value Function (According to Prospect Theory)
-x
x
V(-x)
V(x)
gains
Utility(+)
0losses
Disutility(-)
Value function
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yw
An Illustrative Example
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$200
$400
$600
$800
$1000
Gain Loss Change in Utils
$200
$400
$600
$800
$1000
-80
-60
-40
Change in Utils
-20
-10
+40
+30
+20
+10
+5
What is the Utility for Option A?
What is the Utility for Option B?
Value Creation
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Transaction Utility
Price consumeris willing to pay
Economic Value For the consumer
PricePrice
TransactionUtility
$0
Reference price
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Value CreationDefining VALUEUse Value (Utility)
Savings gained from using a product/service offering Monetary gain from using a product/service offering Satisfaction received from using a product/service offering
Economic Value/Exchange Value Value based on substitutes/alternatives in marketplace Calculated using reference value and differentiation value Economic value is highly contingent on perceptions (or perceived value). Marketing plays a large role in shaping consumer perceptions of a firm’s products/services, as well as those of competitors.
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Illustration of Value: the case of Market Research Valuable
market research helps to provide information and ___________ in decision making
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Value of Information
How much should you pay for such information?
As much as the information is worth, but no more Value of information is based on improved decision.
Value of perfect information vs. value of imperfect information:
Value of _________ information will be LESS!
Example
3M company is considering a new product that targets outdoorsy college students.
The estimated R&D cost is $5 million and the marketing cost is $5 million.
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Market Research
3M company is considering a new product that targets college students.
The estimated R&D cost is $5 million and the marketing cost is $5 million.
Consider two cases (1) there is no uncertainty in the revenue. (2) there is uncertainty in the revenue.
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Case 1: No uncertainty in revenue
The estimated R&D cost is estimated to be $10 million and the marketing cost is $5 million.
Should 3M approve the project if the revenue is $10 million?
Should 3M approve the project if the revenue is $25 million?
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Case 2.1: Uncertainty in revenue
Suppose with 50% of chance, the product will be very popular, bringing $30 million in revenue; and 50% of chance it will be so-so, bringing $20 million.
Notice that the expected revenue is $ 25 million
A market research can ascertain which outcome is going to arise. The cost of doing research is $1 million
Should the research be done? Why?
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Case 2.2: Uncertainty in revenue
Suppose with 50% of chance, the product will be a great success, bringing $40 million in revenue; and 50% of chance it will be a failure, bringing $10 million.
Notice that the expected revenue is again $ 25 million
A market research can ascertain which outcome is going to arise. The cost of doing research is $1 million
Should the research be done? Why?
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Value Creation by Market Research
In case 2.1, what is the value, or the maximal amount of money that the company is willing to pay for the market research?
In case 2.2, what is the value, or maximal amount of money that the company is willing to pay for the market research?
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An important concept:
Expected Value of Perfect Information (EVPI)
Value of Perfect Information
Frequently, information is available that can improve the probability estimates for the states of nature.
The expected value of perfect information (EVPI) is the increase in the expected profit that would result if one knew with certainty which state of nature would occur.
The EVPI provides an upper bound on the expected value of any sample or survey information.
Expected Value of Perfect Information (EVPI)
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The expected value of perfect information is defined as
EVPI = |EMVwPI – EMVwoI|EVPI = |EMVwPI – EMVwoI|
EVPI = expected value of perfect information EMVwPI = expected value with perfect information about the states of nature EMVwoI = expected value without information about the states of nature
where:
Expected Value of Perfect Information (EVPI)
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0
-10
Success
0.5
Failure
0.5
25
0
Approve
Disapprove
Approve
Disapprove
EMV(the best alternative with free perfect info) = 12.5
With perfect information
Approve
Disapprove
Success
0.5
Failure
0.5
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0
-5
EMV(the best alternative without new info) = 10
Without information
Suppose with 50% of chance, the product will be a great success, bringing $40 million in revenue; and 50% of chance it will be a failure, bringing $10 million.
EVPI = EMVwPI - EMVwoI = The most you are willingness to pay for any information
Another way to look at it…
Remember: market research can only be valuable when it can change the status quo course of action when there is no information.
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Calculation 1. Identify the status quo course of action when no
market research is available, by calculating expected revenue and/or expected cost.
2. Identify the scenario in which market research can change the course of action.
3. Determine the gain conditional on that scenario.
4. Multiply the conditional gain and the probability for the occurrence of the scenario.
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A Worked Example
The estimated R&D cost is estimated to be $10 million and the marketing cost is $5 million.
Suppose with 50% of chance, the product will be a great success, bringing $18 million in revenue; and 50% of chance it will be a failure, bringing $10 million.
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Calculation 1. Identify the status quo course of action when no
market research is available, by calculating expected revenue and/or expected cost.
2. Identify the scenario in which market research can change the course of action.
3. Determine the gain conditional on that scenario.
4. Multiply the conditional gain and the probability for the occurrence of the scenario.
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A Final Example (with answer)
The estimated R&D cost is estimated to be $20 million and the marketing cost is $5 million.
Suppose with 1/3 of chance, the product will be a great success, bringing $90 million in revenue; with chance of 1/3 it will be a failure, bringing $15 million revenue, and with 1/3 it will be a disaster and will generate zero revenue.
What is the value of the market research here?
The answer is $11.67 million
Hint: there are 2 scenarios in which the research has the potential to change status quo course of action.
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EVA - based on product differentiation
Reference Valueor
Reference Price
PositiveDifferentiation
Value
NegativeDifferentiation
Value
Total Economic Value
+$
- $Final $
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Importance of Differentiation Value
Selling hot dogs at the street corner of NYC
Your cost
Competitor cost
Case A Case B
Your cost
Competitor cost
WTP
WTP
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Importance of Having Differentiation Value
Netflix Cleanfilms.com
Inventory
Approx. 100,000 Approx. 1,000
# of distribution center
40+ 1
Price charged For 2 at a time
$17.99 $19.99
Secret of survival?
Happy together thereafter?
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A not-so-fairy-tale ending
• In 2006, Judge Richard P. Matsch of the United States District Court for the District of Colorado ruled that it was a copyright violation to distribute re-edited movies without the consent from the movie studios.
• Cleanfilms.com notified its subscribers the loss of the battle while ensuring them that they commit to rent only the “clean” films. • Cleanfilms.com went out of business soon after.
• The Directors Guild of America and the Motion Picture Association of America sued most of these industry players for copyright infringement and claims regarding derivative works.
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Next Lecture
More on Value Creation
Value Measurement & Communication
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